Business Ethics, 9th ed.7-Read+7.pdf · *This case is strictly hypothetical; any resemblance to...

CHAPTER 9

MANAGING AND CONTROLLING ETHICS PROGRAMS

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CHAPTER OBJECTIVES

To define ethics auditing

To identify the benefits and limitations of ethics auditing

To examine the challenges of measuring nonfinancial performance

To explore the stages of the ethics-auditing process

To understand the strategic role of the ethics audit

CHAPTER OUTLINE

Implementing Ethics Programs

The Ethics Audit

Benefits of Ethics Auditing

Ethical Crisis Management and Recovery

Measuring Nonfinancial Performance

Risks and Requirements in Ethics Auditing

The Auditing Process

Secure Commitment of Top

Managers and Board of Directors

Establish a Committee to

Oversee the Ethics Audit

Define the Scope of the Audit Process

Review Organizational Mission,

Values, Goals, and Policies and

Define Ethical Priorities

Collect and Analyze Relevant Information

Verify the Results

Report the Findings

The Strategic Importance of Ethics Auditing

AN ETHICAL DILEMMA*Chantal had been with Butterfly Industries for 13

years. She started out as an assistant buyer and was

later promoted to buyer. She threw herself into her

work, and within a few years she had moved into the

corporate offices.

During Chantal’s tenure, Butterfly Industries

grew from fewer than 500 employees to more than

35,000. The company had expanded all over the

world and opened offices on every continent; it had

nearly exclusive arrangements with suppliers from

six different countries. Such rapid growth eroded the

freedoms of a small firm. So many employees, with

different cultures, languages, and time zones, from so

many countries, each with its own political realities,

made corporate life much more complicated.

To Chantal, it seemed that the firm had grown

at a whirlwind pace, and sometimes she thought

that whirlwind had become an ugly black cloud. She

heard, for example, that some of Butterfly’s suppliers

in Puerto Rico mistreated their workers. In other

foreign locations, Butterfly’s products were bringing

changes to the environment, as well as to local

culture and gender roles. Because Butterfly’s workers

tended to be women, children were being left to fend

for themselves. In some Latin American countries,

husbands were angry because their wives earned

more than they did. Then there were the rumors

that retailers in some countries were selling Butterfly

products without adequate service—or worse, diluting

the products and selling them as “full strength.”




240 Part 4: Implementing Business Ethics in a Global Economy

After Butterfly went public, Chantal’s sense

of foreboding grew. Employees at headquarters

scrambled to satisfy shareholders’ demands for specific

information about products, projected earnings,

employee benefit policies, and equal employment

opportunity records. Chantal was also troubled that so

many of the corporate people were men; only she and

one other woman were directly involved in the inner

workings of the increasingly complex firm.

Six months ago, Chantal began hearing that

some plant employees were suffering pay cuts while

others weren’t. In some cases, employees who had

been working for Butterfly for 15 years were been

cut to 36-hour workweeks, losing their full-time

benefits. She began to notice political alliances being

formed among marketing, finance, manufacturing,

and corporate headquarters. Because each plant

operated as an independent profit-making entity,

each was guarded in its communication with other

plants, knowing that if it could increase its profits it

could also increase overall pay.

Chantal was not the only one to recognize that

Butterfly needed guidance in a variety of areas,

but no one had stepped forward. Then Butterfly’s

president, Jermaine, asked Chantal to lunch. This

was not unusual, but the conversation soon took a

significant twist that Chantal was unprepared for.

“Chantal, you’ve been with the company for

13 years now, right?” asked Jermaine.

“Yes, that’s right,” Chantal answered.

“You know as well as anyone that I haven’t kept

pace with the growth,” Jermaine continued with

a mixture of sadness and determination. “When I

founded this company, I could tell a few staffers to

check out an idea, and several weeks later we’d talk

about whether it would work. There was a time when

I knew every employee, and even their families, but

not anymore. Chantal, I think Butterfly has outgrown

my style of management. What this company needs

is a comprehensive set of rules and guidelines for

every part of the company. I need to delegate more.

That’s why I wanted to talk to you.”

Chantal asked, “Jermaine, what are you saying

to me?”

“Chantal, I’ve always been impressed with your

work ethic and your sense of values. You know this

company and its culture so well. I know you’ve heard

some of the same rumors, so we both know that

all is not well at Butterfly. What I’d like is for you to

become the head of Butterfly’s ethics committee. Of

course, we don’t yet have an ethics committee, so

that’s where you come in.”

“Me?” Chantal asked with surprise.

“Yes, you. If you’re willing, I want you to create

this entity and run it so that we all can be proud of

Butterfly again. So that people inside and outside

the company will know that we stand for what is

right. You will be promoted to vice president, your

salary will be doubled, and you can select your own

team. Chantal, this is your chance to make a huge

difference. What’s your answer?” asked Jermaine.

Chantal hesitated for a moment and then said,

“Yes.”

“Great! I knew I could count on you. The

first thing I need is a proposed outline of the

responsibilities of the new ethics committee,

enforcement procedures—the works—and I want

it in two weeks along with a list of people for the

committee.”

That night, Chantal began to plan.

QUESTIONS | EXERCISES

1. Prioritize the issues that Butterfly needs to deal

with. How can an ethics program address these

issues?

2. Develop an outline of who should be on the

new ethics committee and describe what

the committee’s first steps should be toward

implementing an effective ethics program.

3. Should the new ethics committee commission

an ethics audit? If yes, when should the audit be

conducted? If no, why not?

*This case is strictly hypothetical; any resemblance to real persons,

companies, or situations is coincidental.

In Chapter 8, we introduced the idea of ethics programs as a way for organizations to improve ethical decision making and conduct in business. To properly imple-ment these programs and ensure their effectiveness, companies need to measure




Chapter 9: Managing and Controlling Ethics Programs 241

their impact. Increasingly, companies are applying the principles of auditing to ascertain whether their ethics codes, policies, and corporate values are having a positive impact on the firm’s ethical conduct. These audits can help companies identify risks and areas of non-compliance with laws and company policies as well as other areas that need improvement. An audit should provide a systematic and objective survey of the firm’s ethical culture and values.

We begin this chapter by examining some of the requirements of a successful ethics program. We then discuss the concept of an ethics audit as a way to execute such a pro-gram. We define the term ethics audit and explore its relationship to a social audit. Next, we examine the benefits and limitations of this implementation tool, especially with regard to avoiding a management crisis. We consider the challenges of measuring nonfinancial ethi-cal performance, and review evolving standards from AA1000 and the Open Compliance Ethics Group. We then describe our framework for the steps of an ethics audit, includ-ing securing the commitment of directors and top managers; establishing a committee to oversee the audit; defining the scope of the audit process; reviewing the firm’s mission, values, goals, and policies and defining ethical priorities; collecting and analyzing relevant information; and verifying and reporting the results. Finally, we consider the strategic importance of ethics auditing.

IMPLEMENTING ETHICS PROGRAMS

Developing an effective business ethics program requires organizations to cope with the realities of implementing such a program. Implementation requires executing specific actions that will ensure the achievement of business ethics objectives. The organization must have ways of managing, evaluating, and controlling business ethics programs. Five items in particular can have a significant impact on whether an ethics program is suc-cessful: (1) the content of the company’s code of ethics, (2) the frequency of communica-tion regarding the ethical code and program, (3) the quality of communication, (4) senior management’s ability to successfully incorporate ethics into the organization, (5) and local management’s ability to do the same.1 If an organization has a culture that is more focused on planning than on implementation, employees may come to view unethical conduct as acceptable behavior. Without proper controls in place, lying to customers, manipulat-ing prices, abusive behavior, and misuse of organizational resources can become a part of some employees’ conduct.

Viewing a business ethics program as a part of strategic planning and management activities is critical to the success of any firm. Some companies still do not understand that ethics is a critical aspect of business strategy in action. This misunderstanding stems from a belief that the ethics of employees is primarily an individual matter, and not the respon-sibility of managers. The nature of ethics programs in corporate America is to determine risks, develop policies and codes of conduct, and require specific standards of conduct. However, in order to do the right thing and know when to say no or ask for assistance in gray areas, employees must have a strong sense of personal ethics.

Shared values among employees are the glue of successful management as well as of business ethics programs. When business ethics programs help to align and direct employees’ activities toward an ethical culture, employees will feel a commitment to the long-term ethical progress of the firm. Green Mountain Coffee Roasters, Inc., is a firm





that has been recognized for its emphasis on socially responsible business activities. It has consistently earned a place in Business Ethics/CR Magazine’s “100 Best Corporate Citizens” and was honored by the Society for Human Resource Management for its ethical practices.2 The firm focuses on ethical management and implementation with open communication. It uses a process called the “after-action review” that asks four questions: What did we set out to do? What happened? Why did it happen? What are we going to do about it?

Formal controls for business ethics include input controls such as the proper selection of employees, effective ethics training and strong structural systems (including commu-nication systems). In Chapter 8 we discussed internal control systems whereby employees can report misconduct. Ethics assistance lines, sometimes called hotlines, provide support and give employees the opportunity to get assistance, ask questions, or report concerns. Another internal control system that can improve ethical assistance is an ethics help desk. An ethics help desk is a point of contact within an organization where employees and man-agers can bring their concerns and receive assistance from the most appropriate person in the firm to handle the situation. For this model to be successful, the help desk must be supportive of employees, be easily accessible, and have simple procedures for employees to follow when they express concerns.3

Process controls include management’s commitment to the ethics program and to the methods or system for ethics evaluation. These methods might involve daily coaching for managers and employee reminders regarding appropriate ethical conduct. The best way to provide leadership on ethics is to set a good example, and there are many examples of effective corporate leaders who promote ethics from the top. For example, Jeffrey Swartz, the CEO of Timberland, has won recognition as a strong and ethical corporate leader. Swartz has expanded Timberline’s Green Index—a measurement that shows the product’s environmental impact based on climate impact, chemicals used, and resource consumption—to include its entire footwear collection. He has also announced his com-pany’s commitment to plant 5 million trees in a five-year period. Swartz exhibits good leadership qualities in the care he shows his employees and in his willingness to take responsibility for past mistakes.4

Output controls involve comparing standards with actual behavior. One of the most popular methods of evaluating ethical performance is an ethics audit. The primary purpose of an ethics audit is to identify the risks and problems in outgoing activities and plan the necessary steps to adjust, correct, or eliminate these ethical concerns. Regardless of the complexity of a firm’s ethics program, an ethics audit is critical to the program’s success; therefore, a major part of this chapter focuses on how such audits should be conducted. The Federal Sentencing Guidelines for Organizations’ recent amendment suggests that the results of an ethics audit be reported directly to the board of directors. Such direct reporting would prevent the CEO or another top officer from covering up misconduct.

This chapter will help complete your understanding of how organizational ethics is managed and controlled to create an effective ethics program. Although you may never be in charge of such a program, as a manager or employee you will be part of it. The greater your understanding of the role and function of the various parts of the program, the more effective you will be in engaging and guiding others to make ethical decisions. Business ethics in an organization is not simply a personal matter that is based on your individual values. You will be responsible, both ethically and legally, for engaging in ethical conduct and reporting the unethical conduct of others in your organization.





THE ETHICS AUDIT

An ethics audit is a systematic evaluation of an organization’s ethics program and perfor-mance to determine whether it is effective. A major component of the ethics program described in Chapter 8, the ethics audit includes “regular, complete, and documented mea-surements of compliance with the company’s published policies and procedures.”5 As such, the audit provides an opportunity to measure conformity to the firm’s desired ethical stan-dards. An audit can even be a precursor to setting up an ethics program, as it identifies the firm’s ethical standards as well as its existing policies and risk areas. Recent legislation and FSGO amendments encourage greater ethics auditing as companies attempt to demonstrate to various stakeholders that they are abiding by the law and have established programs to improve ethical decision making. While companies are not required to report the results of their audits to the public, some firms, such as New Belgium Brewing, do report the re-sults of audits in areas such as employment practices, sustainability efforts, and community outreach.

The concept of ethics auditing emerged from the movement to evaluate and report on companies’ broader social responsibility initiatives, particularly with regard to sustainability. An increasing number of companies are auditing their social responsibility programs and reporting the results so as to document their efforts to be more responsible to various in-terested stakeholder groups. A social audit is the process of assessing and reporting on a business’s performance in fulfilling the economic, legal, ethical, and philanthropic respon-sibilities expected of it by its stakeholders.6 Social reports often discuss issues related to a firm’s performance in the four dimensions of social responsibility as well as specific social responsibility and ethical issues such as employment issues, community economic devel-opment, volunteerism, and environmental impact.7 In contrast, ethics audits focus more narrowly on a firm’s ethical and legal conduct. However, an ethics audit can be a compo-nent of a social audit; indeed, many companies include ethical issues in their social audits. Walmart, for example, includes ethical performance in its Sustainability Report.8

Regardless of the breadth of the audit, ethics auditing is a tool that companies can em-ploy to identify and measure their ethical commitment to stakeholders. Employees, custom-ers, investors, suppliers, community members, activists, the media, and regulators are increasingly demanding that compa-nies be ethical and accountable for their conduct. In response, businesses are working to incorporate accountability into their actions, from long-term planning, everyday decision making, and rethinking processes for corporate governance and finan-cial reporting to hiring, retaining, and promoting employees and building relationships with customers. The ethics audit provides an objective method for demonstrating a company’s commit-ment to improving strategic planning, including its compliance with legal and ethical standards and standards of social respon-sibility. The auditing process is important to business because it can improve a firm’s per-formance and effectiveness, increase its attractiveness to investors, improve its relationships with stakeholders, identify potential risks, and decrease the risk of misconduct and adverse publicity that could harm its reputation.9 As we discussed in Chapter 1, the “World’s Most Ethical Companies” have shown better financial performance than the firms in the general stock indexes.

“Ethics auditing is a tool that companies can employ to identify and measure their ethical commitment to stakeholders.”





Ethics auditing employs procedures and processes similar to those found in financial auditing to create an objective report of a company’s performance. As in an accounting audit, someone with expertise from outside the organization may be chosen to conduct an ethics audit. Although the standards used in financial auditing can be adapted to provide an objec-tive foundation for ethics reporting, there are significant differences between the two types of audits. Whereas financial auditing focuses on all systems related to money flow and on financial assessments of value for tax purposes and managerial accountability, ethics auditing deals with the internal and broad external impact of an organization’s ethical performance. Another significant difference is that ethics auditing is not usually associated with regulatory requirements, while financial audits are required of public companies that issue securities. Because ethics and social audits are voluntary, there are fewer standards that a company can apply with regard to reporting frequency, disclosure requirements, and remedial actions that it should take in response to results. This may change as more companies develop ethics pro-grams in the current regulatory environment, in which regulatory agencies support requir-ing boards of directors to oversee corporate ethics. If boards are to track the effectiveness of ethics programs, audits will be required. In addition, nonfinancial auditing standards are de-veloping, with data available for benchmarking and comparing a firm’s nonfinancial ethical performance with its own past performance and with the performance of other firms.

BENEFITS OF ETHICS AUDITING

There are many reasons why companies choose to analyze, report on, and improve their ethical conduct. Assessment of an organization’s ethical culture is necessary to improve ethi-cal performance and to document in legal proceedings that a firm has an effective ethics program. Companies can use ethical audits to detect ethical misconduct before it becomes a major problem, and audits provide evidence of a firm’s attempts to identify and deal with major ethical risks. ATM manufacturer Diebold, Inc., was charged by the Securities and Exchange Commission with manip-ulating earnings from 2002 to 2007 to meet its financial forecasts. This manipulation is estimated to have inflated Diebold’s reported earnings by $127 million. Diebold agreed to settle with the SEC for $25 million, and the company’s former chief executive agreed to pay back $470,000.10 Such accounting scandals and legal and ethical transgressions have encouraged companies to better account for their actions in a wide range of areas, including corporate governance, ethics pro-grams, customer relationships, employee relations, environmental policies, and community involvement.

One company may want to achieve the most ethical performance possible, whereas another may use an ethics audit merely to project a good image to hide its corrupt culture. Top managers might use an ethics audit to identify ethical problems in their companies, but identification alone does not mean that they will take steps to correct these lapses through punishments or sanctions.11 Without appropriate action on the part of management, an ethics audit can be mere lip service intended to enhance the firm’s reputation without actu-ally improving its ethical conduct. Other firms might conduct ethics audits in an attempt to comply with the Federal Sentencing Guidelines for Organizations, (FSGO) require-ments that the board of directors oversee the discovery of ethical risk, design and imple-ment an ethics program, and evaluate performance. Some companies view the auditing process as tied to continuous improvement, which is closely related to improved financial performance. Companies’ reasons for supporting the FSGO are complex and diverse. For





example, it is common for firms to conduct audits of business practices with legal ramifi-cations such as employee safety, environmental impact, and financial reporting. Although these practices are important to a firm’s ethics and social responsibility, they are also legally required and therefore constitute the minimum level of commitment. However, because stakeholders are demanding increased transparency and taking a more active role through external organizations that represent their interests, government regulators are calling on companies to improve their ethical conduct and make more decisions based on principles rather than on laws alone.

Measuring the ethical work climate of an organization is one way to learn about its ethical culture. While most measurements of ethical climate are conducted by academic researchers, some firms are becoming proactive in working with consultants to measure their ethical climate. Some measures of ethical climate include collective ethical sensitivity (empathetic concern and awareness), collective character, collective judgment (focus on others and focus on self), and collective moral motivation.12 These measures can be used to help evaluate changes in a firm’s ethical culture after the development of ethics programs.

The auditing process can highlight trends, improve organizational learning, and facilitate communication and working relationships.13 Auditing can also help companies assess the effectiveness of their programs and policies, which often improves their operat-ing efficiencies and reduces costs. Information from audits and reports can allow a com-pany to ensure that it is achieving the greatest possible impact with available resources.14 The process of ethics auditing can also help an organization identify potential risks and liabilities and improve its compliance with the law. Furthermore, the audit report may help document a firm’s compliance with legal requirements as well as demonstrate its progress in areas where it previously failed to comply, for example by describing the systems it is implementing to reduce the likelihood of a recurrence of misconduct.15

For organizations, one of the greatest benefits of the auditing process is improved relationships with stakeholders who desire greater transparency. Many stakeholders have become wary of corporate public relations campaigns. Verbal assurances by cor-porate management are no longer sufficient to gain stakeholders’ trust. An ethics audit could have saved Countrywide Financial if liar loans and the manipulation of borrowers’ financial data had been identified earlier. When companies and their employees, suppliers, and investors trust each other, the costs of monitoring and managing these relationships are lower. Companies experience less conflict with these stakeholders, which results in a heightened capacity for innovation and collaboration.

Because of these benefits shareholders and investors have welcomed the increased dis-closure that comes with corporate accountability. Table 9.1 indicates the top challenges that CEOs will be facing in the future. Keeping pace with regulation, protecting against risks, and reputation management are three of the top 10 challenges. These issues can be con-sidered major risks associated with managing and controlling ethics programs. Therefore, they represent key areas that could be important in an ethics audit. A growing number of investors are considering nonfinancial measures—such as the existence of ethics programs, legal compliance, board diversity and independence, and other corporate governance issues like CEO compensation—when they analyze the quality of current and potential invest-ments. Research suggests that investors may be willing to pay higher prices for the stock of companies that they deem to be accountable,16 such as stock from Fortune’s “World’s Most Admired Companies,” including Adobe Systems, Whirlpool, Berkshire Hathaway, Google, Marriott International, Procter & Gamble, 3M, Deere, UPS, and BMW, who have generally avoided major ethical disasters.17





However, even companies that have experienced legal issues or have had their ethics questioned can make a comeback. Walmart CEO Mike Duke has been recognized for his leadership in the arena of business ethics as a result of his investment in sustainable sup-ply chain practices. Under his leadership, Walmart has set forth an ambitious initiative to “green” its supply chain. The company is asking its suppliers to examine the carbon life-cycle of its products and make meaningful changes in sourcing, manufacturing, packaging, and transporting products. Walmart also plans to reduce greenhouse gas emissions from its supply chain by 20 million metric tons by 2015. Duke agreed that the company would invest $1 billion over the next five years to create a more sustainable supply chain. The company has strived to learn from its mistakes, settling more than 60 wage and hour abuse lawsuits. Walmart consistently ranks near the top of Fortune’s Most Admired Companies in spite of past ethical and legal concerns.18

Regular audits permit shareholders and investors to judge whether a firm is achiev-ing the goals it has established, and whether it abides by the values that it has specified as important. Moreover, it permits stakeholders to influence the organization’s behavior.19 Increasingly, a broad range of stakeholder groups are seeking specific, often quantifiable, information from companies. These stakeholders expect companies to take a deeper look at the nature of their operations and to publicly disclose their progress and problems in addressing these issues. Some investors are using their rights as stockholders to encourage companies to modify their plans and policies to address specific ethical issues. On a broader scale, the Obama administration sought to impose limits on executive compensation of those firms seeking government financial support. The 2010 passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act implemented new regulations for execu-tive compensation. Under these new provisions, shareholders of public companies can cast advisory votes on whether they approve of the compensation awarded to top executives. Additionally, top executives must provide more disclosure on how their compensation aligns with the company’s financial performance.20

TABLE 9.1 Top Challenges for CEOs

1. Managing growth

2. Employee turnover

3. Customer relationships

4. Social media

5. Regulatory issues

6. Risk management

7. Globalization

8. Reputation

9. Technology competence

10. Competitive advantage

Source: Adapted from Sheryl Nance-Nash, “Top Challenges for CEOs in 2011,” Daily Finance,

December 15, 2010, http://www.dailyfinance.com/story/top-10-challenges-for-corporate-

ceos-in-2011/19760107/ (accessed March 23, 2011).





Ethical Crisis Management and RecoveryA significant benefit of ethics auditing is that it may help prevent crises resulting from ethical or legal misconduct, crises that can potentially be more devastating than natural disasters or technological disruptions. Just as companies develop crisis management plans to respond to and recover from natural disasters, they should also prepare for ethical di-sasters, which can not only result in substantial legal and financial costs but which can also disrupt routine operations, paralyze employees, reduce productivity, destroy organizational reputation, and erode stakeholder confidence. Ethical and legal crises have resulted in the demise or acquisition of a number of well-known companies including Lehman Brothers, Merrill Lynch, and Washington Mutual. Many other companies—HealthSouth, Firestone, Waste Management, Rite Aid, U.S. Foodservice, Qwest, Kmart, Mitsubishi Motors, and Archer Daniels Midland, for example—have survived ethical and legal crises but paid a high price both financially and in terms of compromised reputation and diminished stake-holder trust. In recent years, companies have spent up to $7 million a month on outside legal counsel to defend against alleged organizational wrongdoing. One study found that publicity about unethical corporate behavior lowers stock prices for at least six months.21

For example, bribery allegations and an internal bribery probe at Avon Products, Inc., tem-porarily lowered its share prices because of fears that a scandal could harm operations.22

Organizational members who engage in questionable or even illegal conduct are guilty of ethical misconduct, and these employees can threaten the overall integrity of the organi-zation. Top leaders in particular can magnify ethical misconduct to disastrous proportions. The misconduct of Raj Rajaratnam at the Galleon Group, Andrew Fastow at Enron, Dennis Kozlowski at Tyco, and Bernie Ebbers at WorldCom, among others, has caused financial disasters on both organizational and global levels.23 An ethics audit can uncover rogue em-ployees who are violating the firm’s ethical standards and policies or laws and regulations.

Ethical disasters follow recognizable phases of escalation, from ethical issue recogni-tion and the decision to act unethically to the organization’s discovery of and response to the act. Appropriate anticipation of and intervention during these situations can stave off major problems. Such contingency planning assesses risks, plans for eventualities, and pro-vides ready tools for responding to ethical crises. The process of ethical disaster-recovery planning involves assessing an organization’s values, developing an ethics program, per-forming an ethics audit, and developing contingency plans for potential ethical disasters. The ethics audit itself provides the key to preventing ethical disasters.

Formal mechanisms should be in place to discover risk as a part of evaluating compliance and the effectiveness of ethics programs. The greatest fear of most corporate leaders is dis-covering misconduct or illegal activity that could be reported by the mass media, used by competitors, or prosecuted by the government. Yet this process is extremely important to the long-term well-being of an organization. While risks such as earthquakes, fires, hurricanes, and other natural disasters can-not always be determined, companies can plan for these types of disasters. Unfortunately, ethical risks are often given the lowest priority. Table 9.2 lists the wide range of approaches that companies use to manage risks. Only about one-fourth of the companies surveyed by the Open Compliance Ethics Group had a risk management committee that was separate from the audit committee as part of its board of directors. As Table 9.2 indicates, 14 percent of the firms report having no risks team at all.

“The greatest fear of most corporate leaders is discovering misconduct or illegal activity.”





TABLE 9.2 How Do Corporations Manage Risk?

Incorporation of risk management into business management strategies 28%

Teams that combine business management and internal audits 25%

Independent risk management teams 26%

Risk management as part of internal audit 7%

No formal risk team or committee 14%

Source: Survey of 250 respondents conducted by the Open Compliance Ethics Group, April 2010, http://www.oceg.org/resource/

oceg-one-minute-poll-how-do-you-manage-risk (accessed March 23, 2011).

Measuring Nonfinancial Ethical PerformanceAlthough much of the regulation of corporate ethics and compliance is focused on financial measures, to truly have integrity, an organization also has to focus on nonfinancial areas of performance. The word integrity in this context implies a balanced organization that not only makes ethical financial decisions but also is ethical in the more subjective aspects of its corporate culture. The Sarbanes–Oxley Act has focused on questionable accounting and the metrics that destroy shareholder value, but other models have been developed—such as Six Sigma, the Balanced Scorecard, and the triple bottom Line—to capture structural and behavioral organizational ethical performance. Six Sigma is a methodology designed to manage process variations that cause defects, defined as unacceptable deviations from the mean or target, and to systematically work toward managing variation to eliminate those defects. The objective of Six Sigma is to deliver world-class performance, reliability, and value to the end customer. The Balanced Scorecard is a management system that focuses on all the elements that contribute to organizational performance and success, including fi-nancial, customer, market, and internal processes. Its goal is to develop a broader perspec-tive on performance factors and to foster a culture of learning and growth that improves all organizational communication. The triple bottom line provides a perspective that takes into account the social, environmental, and financial impacts of decisions made within an organization. When making an increased commitment to social responsibility, sustain-ability, or ethics, companies consider implementing triple bottom line reporting as a way to confirm that their investments and initiatives are supporting their organization’s values and overall success. Table 9.3 provides additional detail on these three measurement tools. The purpose of a variety of measures of performance and goal achievement is to determine the quality and effectiveness of environmental, social, and ethics initiatives. Many believe that an inherent gain is realized by companies with strong ethical cultures and environmental commitments, paid in customer commitment and in avoiding the negative publicity and costs associated with wrongdoing.

The Global Reporting Initiative (GRI) has become a prominent framework that com-panies have adopted to report their social and sustainability progress.24 The GRI advances sustainability reporting, which incorporates the triple bottom line factors of economic, so-cial, and environmental indicators. The primary goal of the GRI is “the mainstreaming of disclosure on environmental, social, and governance performance.”25 Businesses can use the GRI to come up with a more standardized method of reporting nonfinancial results in a way that users of the reports can understand. Companies benefit because the GRI





provides tools for improving their implementation of the triple bottom line, as well as as-sisting with the disclosure of their progress in this area and giving them the ability to com-pare their sustainability efforts with those of other companies and the chance to enhance their reputation in the eyes of stakeholders. Users benefit because this standardized sus-tainability reporting gives them a point of comparison with other companies’ sustainability initiatives.26 GRI continually revises its framework to ensure that it remains relevant and encourages multiple stakeholders from global business, civil society, labor, and academic sectors to participate in the process.27

AccountAbility is an international membership organization committed to enhancing the performance of organizations and to developing the competencies of individuals in social and ethical accountability and sustainable development. Figure 9.1 illustrates the Ac-countAbility AA1000 framework for ethics and social responsibility. The AA1000 process standards link the definition and embedding of an organization’s values to the develop-ment of performance targets and to the assessment and communication of organizational performance. Through this process, focused around the organization’s engagement with stakeholders, AA1000 ties social and ethical issues into the organization’s strategic manage-ment and operations. AA1000 recognizes these different traditions. It combines the terms social and ethical to refer to the systems and individual behavior within an organization, as well as to the direct and indirect impact of an organization’s activities on stakeholders. Social and ethical issues (relating to systems, behavior, and impacts) are defined by an organization’s values and aims, as shaped by the influence of the interests and expectations of its stakeholders and by societal norms and expectations. Assessment means measuring

TABLE 9.3 Description of Measurement Tools

Measurement Systems Description

Balanced Scorecard Developed by Drs. Robert Kaplan and David Norton, the Balanced

Scorecard incorporates nonfinancial performance indicators into the

evaluation system to provide a more “balanced” view of organizational

performance. The system uses four metrics—financial, internal

business processes, learning and growth, and customer—to measure

the overall performance of the firm.

Six Sigma Six Sigma focuses on improving existing processes that do not meet

quality specifications or that need to be improved as well as developing

new processes that meet Six Sigma standards. To meet Six Sigma

specifications, the process must not produce more than 3.4 defects

per million opportunities.

Triple Bottom Line This approach to measuring social, financial, and environmental

factors (or people, places, and planet) recognizes that business has a

responsibility to positively influence a variety of stakeholders, including

customers, employees, shareholders, community, and the natural

environment. The challenge is how to evaluate a business’s social and

environmental impacts, since there are no universally standard forms

of measuring these criteria.

Source: “Balanced Scorecard Basics,” Balanced Scorecard Institute, http://www.balancedscorecard.org/BSCResources/AbouttheBalancedScorecard/

tabid/55/Default.aspx (accessed March 23, 2011); “What is Six Sigma,” iSix Sigma, http://www.isixsigma.com/index.php?option=com_

k2&view=item&id=1463:what-is-six-sigma?&Itemid=155 (accessed March 23, 2011); “Triple bottom line,” The Economist, November 17, 2009,

http://www.economist.com/node/14301663?story_id=14301663 (accessed March 23, 2011).





organizational responsiveness or the extent to which an organization takes action on the basis of stakeholder engagement. This is followed by assurance, including control mecha-nisms, and then reporting to document the process. The embedding of an organization’s values to assure performance is a continuous process.

Figure 9.2 shows the Open Compliance Ethics Group’s functions of governance, risk, and compliance framework. The Open Compliance Ethics Group (OCEG) (http://www.oceg.org) has worked with more than 100 companies to create a universal framework for compliance and ethics management. The OCEG focuses on nonfinancial compliance and the more qualitative elements of internal controls. The OCEG framework deals with complex issues of compliance and solutions to address the development of organizational ethics. By establishing guidelines rather than standards, OCEG provides a tool for each company to use as it sees fit, given its size, scope, structure, industry, and other factors that create individualized needs. The OCEG guidelines and benchmarking studies can be very valuable to a firm conducting an ethics audit. Most significant is the opportunity to com-pare an organization’s activities to those of other organizations. To this end, the OCEG has created tools and certification procedures to help businesses, such as the Burgundy Book, which assists in assessing “the design and operation of government, risk management, and compliance processes.”28 Additionally, the organization awards certification to companies

Assessment

EmbeddingValues

Reporting Assurance

Accountability

Stakeholder Engagement

FIGURE 9.1 AA1000 Framework for Ethics and Social Accountability

Source: Adapted from AccountAbility AA1000 Series of Standards, http://www.accountability21.net/aa1000series (accessed March 12, 2009).

Reprinted with permission of The Institute of Social and Ethical Accountability.





and individuals that demonstrate to stakeholders that they operate at the highest standards regarding governance, risk management, and compliance.29

Risks and Requirements in Ethics AuditingAlthough ethics audits provide many benefits for individual companies and their stake-holders, they do have the potential to create risks. For example, a firm may uncover a seri-ous ethical problem that it would prefer not to disclose until it has remedied the situation. It may find that one or more of its stakeholders’ criticisms cannot be easily addressed. Occasionally, the process of conducting an ethics audit may foster stakeholder dissatis-faction rather than stifle it. Moreover, the auditing process imposes burdens (especially with regard to record keeping) and costs for firms that undertake it. Auditing, although a prudent measure, provides no assurance that ethical risks and challenges can be avoided. Another challenge is in assessing risk and identifying standards of comparison. How can a company sufficiently analyze and manage its risks, and what goals for improvement should it develop? Some initiatives to benchmark risk assessment and best practices have begun to emerge, but this process is in its early stages.

Many companies suspected of misconduct respond to public scrutiny of their prac-tices by conducting an ethics audit to show their concern and respond appropriately to weaknesses in their ethics programs. Companies in the public eye as a result of question-able conduct or legal violations, such as AIG, Fannie Mae, Freddie Mac, and Merrill Lynch, should conduct ethics audits to demonstrate their visible commitment to improving deci-sion making and business conduct.

Research suggests that generating ethics and corporate social responsibility auditing procedures can be tricky because of a lack of standardization and widely accepted mea-sures.30 Although ethics and social responsibility are defined and perceived differently by various stakeholders, a core of minimum standards for ethical performance is evolving.

LegalFederal Sentencing Guidelines

Quality

Management

Corporate Governance

Human CapitalManagement

Ethics,Values,

Integrity

Internal Control

FIGURE 9.2 Roles and Functions of Risk, Management, and Compliance

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These standards represent a fundamental step in the development of minimum ethics re-quirements that are specific, measurable, achievable, and meaningful to a business’s impact on communities, employees, consumers, the environment, and economic systems. They help companies set measurable and achievable targets for improvement, and they form an objective foundation for reporting the firm’s efforts to all direct stakeholders. Disagree-ments may still arise over key issues, but overall these standards should enable companies to make progress in meeting their goals. The FSGO’s seven steps for effective ethical com-pliance, discussed in Chapters 3 and 8, as well as the Sarbanes–Oxley Act and the Dodd–Frank Act, provide standards that organizations can use in ethics auditing.

THE AUDITING PROCESS31

There are many questions to address when conducting an audit, such as how broad the audit should be, what standards of performance should be applied, how often the audit should be conducted, whether—and how—the audit’s results should be reported to stake-holders, and what actions should be taken in response to audit results. Therefore, corpo-rate approaches to ethics audits are as varied as their approaches to ethics programs and their responses to improving social responsibility.

It is our belief that an ethics audit should be unique to each company, reflecting its size, industry, corporate culture, and identified risks as well as the regulatory environment in which it operates. Thus, an ethics audit for a bank will differ from one for an automo-bile manufacturer or a food processor. Each company has different regulatory concerns and unique risks stemming from the nature of its business. For this reason, we have mapped out a framework (see Table 9.4) that is somewhat generic and that most companies can expand on when conducting their own ethics audits. The steps in our framework can also be applied to broader social audits that include specific ethical issues as well as other economic, legal, and philanthropic concerns of interest to various stakeholders. As with any new initiative, com-panies may choose to begin their effort with smaller, less formal audits and work up to more

TABLE 9.4 Framework for an Ethics Audit

ethics audit

priorities

Sources: These steps are compatible with the social auditing methods prescribed by Warren Dow and Roy Crowe in What Social Auditing Can Do for

Voluntary Organizations (Vancouver: Volunteer Vancouver, July 1999), and Sandra Waddock and Neil Smith in “Corporate Responsibility Audits: Doing

Well by Doing Good,” Sloan Management Review 41 (2000): 79.





comprehensive social audits. For example, a firm may choose to focus on primary stakehold-ers in its initial audit year and then expand to secondary groups in subsequent audits.

Our framework encompasses a wide range of business responsibilities and relation-ships. The audit entails an individualized process and outcomes for a particular firm, as it requires a careful consideration of the unique issues that face a particular organization. For example, the auditing process at Coca-Cola must consider several factors specific to that company. To ensure an effective internal audit, Coca-Cola’s board of directors appoints a special audit committee whose responsibilities include a review of the company’s financial statements as well as an assessment of its risk management, internal and disclosure con-trols, complaints procedures, and compliance programs (including the Company’s Code of Business Conduct). The committee’s statement of purpose is as follows:

The Committee will represent and assist the Board in fulfilling its oversight responsi-bility to the shareowners and others relating to the integrity of the Company’s financial statements and the financial reporting process, the systems of internal accounting and financial controls, the internal audit function, the annual independent audit of the Com-pany’s financial statements, the Company’s compliance with legal and regulatory require-ments, and its ethics programs as established by management and the Board, including the Company’s Code of Business Conduct. The Committee shall also oversee the inde-pendent auditors’ qualifications and independence. The Committee will evaluate the performance of the Company’s internal audit function (responsibilities, budget and staffing) and the Company’s independent auditors, including a review and evaluation of the engagement partner and coordinating partner. In so doing, it is the responsibility of the Committee to maintain free and open communication between the Committee, in-dependent auditors, the internal auditors and management of the Company. The Com-mittee is also responsible for producing an annual report for inclusion in the Company’s proxy statement.32

Figure 9.3 provides a fictional example of how a corporate social responsibility struc-ture might be organized within a well-known company. Notice that the 2010 amendments to the Federal Sentencing Guidelines for Organizations recommend that chief ethics and compliance officers report directly to the board of directors. Although this chapter pres-ents a structure and recommendations for both general social and ethics-specific audits, there is no generic approach that will satisfy every firm’s circumstances. Nevertheless, the benefits and limitations that companies derive from auditing are relatively consistent.

Secure Commitment of Top Managers and Board of DirectorsThe first step in conducting any audit is securing the commitment of the firm’s top man-agement and, if it is a public corporation, its board of directors. Indeed, the push for an ethics audit may come directly from the board itself in response to specific stakeholder concerns or corporate governance reforms related to the Sarbanes–Oxley Act, which sug-gests that boards of directors should provide oversight for all auditing activities. In addi-tion, court decisions related to the FSGO hold board members responsible for the ethical and legal compliance programs of the firms they oversee. Rules and regulations associated with the Sarbanes–Oxley Act require that boards include members who are knowledge-able and qualified to oversee accounting and other types of audits to ensure that these re-ports are accurate and include all material information. Although a board’s financial audit





committee will examine ethical standards throughout the organization as they relate to financial matters, it will also deal with the implementation of codes of ethics for top finan-cial officers. Many of those issues relate to such corporate governance issues as compensa-tion, stock options, and conflicts of interest. An ethics audit can demonstrate that a firm has taken steps to prevent misconduct, which can be useful in cases where civil lawsuits blame the firm and its directors for the actions of a rogue employee.

Pressure for an audit can also come from top managers who are looking for ways to track and improve ethical performance and perhaps give their firm an advantage over competitors that are facing questions about their ethical conduct. Additionally, under the Sarbanes–Oxley Act, CEOs and CFOs may be criminally prosecuted if they know-ingly certify misleading financial statements. They may request an ethics audit as a tool to help improve their confidence in their firm’s reporting processes. Some companies have established a high-level ethics office in conjunction with an ethics program, and the eth-ics officer may campaign for an ethics audit as a way to measure the effectiveness of the firm’s ethics program. Regardless of where the impetus for an audit comes from, its suc-cess hinges on the full support of top management, particularly the CEO and the board of directors. Without this support, an ethics audit will not improve the firm’s ethics program or the corporate culture.

Establish a Committee to Oversee the Ethics AuditThe next step in our framework is to establish a committee or team to oversee the au-dit process. Ideally, the board of directors’ financial audit committee would oversee the ethics audit, but this does not happen in most companies. In most firms, managers or

FIGURE 9.3 Model Corporate Social Responsibility Structure

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ethics officers, who do not always report to the board of di-rectors, conduct social and ethics auditing. In any case, this team should include employees who are knowledgeable about the nature and role of ethics audits, and those people should come from various departments within the firm. The team may recruit individuals from within the firm or hire outside consultants to coordinate the audit and report the results di-rectly to the board of directors. The Ethics Resource Center, a nonprofit organization engaged in supporting ethical con-duct in the public and private sector, assists companies with assessments and audits of their ethics programs.33 As with a financial audit, an external auditor should not have other con-sulting or conflict-of-interest relationships with top managers or board members. Based on the best practices of corporate governance, audits should also be monitored by an in-dependent board of directors’ committee, as recommended by the Sarbanes–Oxley Act.

Define the Scope of the Audit ProcessThe ethics audit committee should establish the scope of the audit and monitor its progress to ensure that it stays on track. The scope of an audit depends on the type of business, the risks it faces, and the opportunities it has available to manage ethics. This step includes defining the key subject matter or risk areas that are important to the ethics audit (for example, sustainability, discrimination, product liability, employee rights, privacy, fraud, financial reporting, and/or legal compliance) as well as the bases on which these areas should be assessed. Assessments can be made on the basis of direct consultation, observa-tion, surveys, or focus groups.34 Table 9.5 lists some sample subject matter areas and the audit items for each.

Review Organizational Mission, Values, Goals, and Policies and Define Ethical Priorities

Because ethics audits generally involve comparing an organization’s ethical performance to its goals, values, and policies, the audit process should include a review of the current mis-sion statement and strategic objectives. A company’s overall mission may incorporate ethics objectives, but these may also be found in separate documents, including those that focus on social responsibility. For example, a firm’s ethics statement or statement of values may offer guidance for managing transactions and human relationships that support the firm’s reputa-tion, thereby fostering the confidence of the firm’s external stakeholders.35 Franklin Energy, for example, specifies the five core values it uses in managing its business, and which con-tribute to its success: ingenuity, results orientation, frugality, integrity, and environmental stewardship.36

This review step should include an examination of all formal documents that make explicit commitments to ethical, legal, or social responsibility, as well as less formal docu-ments including marketing materials, workplace policies, ethics policies, and standards for suppliers or vendors. This review may reveal a need to create additional statements to fill the identified gaps or to create a new comprehensive mission statement or ethical policy that addresses any deficiencies.37

“An external auditor should not have other consulting or conflict-of- interest relationships with top managers or board members.”





TABLE 9.5 The Ethics Audit

Organizational Issues*

Yes No 1. Does the company have a code of ethics that is reasonably capable of

preventing misconduct?

Yes No 2. Does the board of directors participate in the development and evaluation of

the ethics program?

Yes No 3. Is there a person with high managerial authority responsible for the ethics

program?

Yes No 4. Are there mechanisms in place to prevent the delegation of authority to

individuals with a propensity for misconduct?

Yes No 5. Does the organization effectively communicate standards and procedures to

its employees via ethics training programs?

Yes No 6. Does the organization communicate its ethical standards to suppliers,

customers, and significant others that have a relationship with the

organization?

Yes No 7. Do the company’s manuals and written documents guiding operations contain

messages about appropriate behavior?

Yes No 8. Is there formal or informal communication within the organization about

procedures and activities that are considered acceptable ethical behavior?

Yes No 9. Does top management have a mechanism in place to detect ethical issues

relating to employees, customers, the community, and society?

Yes No 10. Is there a system in place for employees to report unethical behavior?

Yes No 11. Is there consistent enforcement of standards and punishments

in the organization?

Yes No 12. Is there a committee, department, team, or group that deals with ethical

issues in the organization?

Yes No 13. Does the organization make a continuous effort to improve its ethical

compliance program?

Yes No 14. Does the firm perform an ethics audit?

Examples of Specific Issues That Could Be Monitored in an Ethics Audit†

Yes No 1. Are there any systems or operational procedures in place to safeguard

individual employees’ ethical behavior?

Yes No 2. Is it necessary for employees to break the company’s ethical rules to get

the job done?

Yes No 3. Is there an environment of deception, repression, and cover-ups concerning

events that would embarrass the company?

Yes No 4. Are there any participatory management practices that allow ethical issues

to be discussed?

Yes No 5. Are compensation systems totally dependent on performance?

Yes No 6. Does sexual harassment occur?

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It is also important to examine all of the firm’s policies and practices with respect to the specific areas covered by the audit. For example, in an audit that scrutinizes dis-crimination issues, this review step would consider the company’s goals and objectives as well as its policies related to discrimination. It would consider the means available for communicating the firm’s policies and assess their effectiveness. Such an evalua-tion should also look at whether and how managers are rewarded for meeting their goals and the systems employees have through which to give and receive feedback. An effective ethics audit will review all these systems and assess their strengths and weaknesses.38

Concurrent with this step in the auditing process, the firm should define its ethical priorities. Determining these priorities is a balancing act because identifying the needs and assessing the priorities of each stakeholder can be difficult. Because there may be no legal requirements for ethical priorities, it is up to management’s strategic planning processes to determine risks, designate appropriate standards, and outline processes of communication with stakeholders. It is very important at this stage to articulate the firm’s ethical priorities and values as a set of parameters or performance indicators that can be objectively and quantitatively assessed. Because the ethics audit is a structured report that offers quantitative and descriptive assessments, actions should be measur-able by quantitative indicators. However, it is sometimes not possible to go beyond description.39

At some point, a firm must demonstrate action-oriented responsiveness to those ethics issues to which it has given top priority. For example, Niagara Mohawk Power Co. has a long history of working to minimize damage to the environment. The firm has adopted the inter-national standard for environmental management systems, ISO 14001, and the guidelines specified by ISO 14001 require external auditing by a certified auditor. Additionally, Niagara Mohawk has a global Corporate Responsibility Summary Report on its corporate website.40

Yes No 7. Does any form of discrimination—race, sex, or age—occur in hiring,

promotion, or compensation?

Yes No 8. Are the only standards about environmental impact those that are legally required?

Yes No 9. Do the firm’s activities show any concern for the ethical value systems of the

community?

Yes No 10. Are there deceptive and misleading messages in promotion?

Yes No 11. Are products described in misleading or negative ways or without

communicating their limitations to customers?

Yes No 12. Are the documents and copyrighted materials of other companies used in

unauthorized ways?

Yes No 13. Are expense accounts inflated?

Yes No 14. Are customers overcharged?

Yes No 15. Does unauthorized copying of computer software occur?

*A high number of “Yes” answers indicates that ethical control mechanisms and procedures are in place within the organization.

†The number of “Yes” answers indicates the number of possible ethical issues to address.





Collect and Analyze Relevant InformationThe next step in the ethical audit framework is to identify the tools or methods for mea-suring a firm’s progress in improving employees’ ethical decisions and conduct. In this step, the firm should collect relevant information for each designated subject matter area. To understand employee issues, for example, the auditing committee should work with the firm’s human resources department to gather employee survey information and other statistics and feedback. A thorough ethics audit will review all relevant reports, including external documents sent to government agencies and others. Attempts to measure a firm’s sustainability strategy will often depend upon a company’s own reports and secondary data.41 The information collected in this measurement step should help determine base-line levels of compliance as well as the internal and external expectations of the company. This step will also identify where the company has, or has not, met its commitments, including those dictated by its mission statement and other policy documents. The docu-ments reviewed in this process will vary from company to company, depending on the firm’s size and the nature of its business, as well as the scope of the audit process.42 At Green Mountain Coffee, the audit committee of the board of directors is responsible for providing oversight of reporting procedures and audits. Green Mountain’s code of ethics, described in Table 9.6, provides a framework for the principles that are the backbone of the ethics audit.43

Some techniques for collecting evidence might involve examining both internal and external documents, observing the data-collection process (for example by consulting with stakeholders), and confirming information in the organization’s accounting records. Auditors may also employ ratio analysis of relevant indicators to identify any inconsistencies or unex-pected patterns. Objective measurement is the key consideration of the ethics auditor.44

Stakeholder involvement is another important component in the successful imple-mentation of an ethics audit, as stakeholders can yield significant insights. In one study

TABLE 9.6 Green Mountain Coffee’s Code of Ethics

and resources

on consistent communications

business partners to do so as well

Source: Adapted from GMC’s Code of Ethics, http://files.shareholder.com/downloads/GMCR/1200861996x0x383775/36dbb352-934f-4e7b-9001-

9d0c581a6410/GMCR_WebDoc_7206.pdf (accessed March 23, 2011).





examining reporting channels, employees were asked to whom they would “feel comfort-able” reporting misconduct if they suspected or became aware of it. Supervisors and local managers received the most favorable responses, suggesting the need for organizations to ensure that front-line managers are equipped to respond appropriately to allegations. It is worth noting that those functions primarily charged with taking action in response to alleged misconduct (legal, internal audit, and board or audit committee functions) were cited among the less likely channels that employees would feel comfortable using to report allegations. A company’s ethical culture also determines whether those who report misconduct experience retaliation—and could also determine how often em-ployees feel comfortable enough to report misconduct. Figure 9.4 shows that retaliation occurs more often in weaker ethical cultures. This makes it essential for management to create a strong ethical culture in which employees are encouraged to report observed misconduct.

Because integrating stakeholder feedback in the ethics audit process is so crucial, these stakeholders must first be defined and then interviewed during the data-collection stage. For most companies, stakeholders include employees, customers, investors, suppli-ers, community groups, regulators, nongovernment organizations, and the media. Both social and ethics audits typically interview and conduct focus groups with these stake-holders to gain an understanding of how they perceive the company. For example, the Chris Hani Baragwanath Hospital (CHBH) in Johannesburg, South Africa, conducted an ethics audit that included focus groups with the hospital’s management, doctors, nurses, related health professionals, support staff, and patients. Using the trends uncovered in these focus groups, CHBH then developed an ethics survey questionnaire that it admin-istered to a larger group of individual stakeholders.45 The more stakeholders that auditors include in this measurement stage, the more time and resources the audit will consume. However, a larger sample of stakeholders may yield a more useful variety of opinions

FIGURE 9.4 Correlation between Retaliation and Corporate Culture

Source: Retaliation: The Cost to Your Company and Its Employees, (Arlington, VA: Ethics Resource Center, 2010), p. 10.





about the company. Multinational corporations must also make decisions about whether to include in the audit only the main office or headquarters region or all of its facilities around the globe.46

Because employees carry out a business’s operations, including its ethics initiatives, understanding employee issues is vital to a successful audit. Useful indicators for as-sessing employee issues include staff turnover and employee satisfaction. High turnover rates could indicate poor working conditions, an unethical culture, inadequate com-pensation, or general employee dissatisfaction. Companies can analyze these factors to determine key areas for improvement.47 Questionnaires that survey employees’ percep-tions of the ethics of their company, their superiors, their coworkers, and themselves, as well as ratings of ethical or unethical practices within the firm and industry, can serve as benchmarks in an ongoing assessment of ethical performance. Then, if unethical behavior increases, management will better understand what types of unethical prac-tices may be occurring and why. For example, the CHBH ethics survey asked employees about many issues, including corporate culture and values, their work space, human resources issues, misconduct, standards of patient care, and problems and sources of stress.48 Most organizations recognize that employees will behave in ways that lead to recognition and rewards and avoid behavior that results in punishment. Therefore, companies can design and implement human resources policies and procedures for re-cruiting, hiring, promoting, compensating, and rewarding employees that encourage ethical behavior.49

Customers are another primary stakeholder group because their patronage and loy-alty determines a company’s financial success. Providing meaningful feedback is critical to creating and maintaining customer satisfaction. Through surveys and customer-initiated communication systems such as response cards, online social networks, e-mail, and toll-free numbers, organizations can monitor and respond to customer issues and its perceived social performance. Procter & Gamble uses online social networking sites such as Face-book to determine which social issues consumers are passionate about, as well as to gain insights into consumers’ product needs and reactions to products.

A growing number of investors are seeking to include in their investment portfolios the stocks of companies that conduct ethics and social audits. They are becoming more aware of the financial benefits that can stem from socially responsible management systems—as well as the negative consequences of a lack of responsibility. President Obama praised City National Bancshares CEO Leonard Abess after he distributed his entire $60 million bonus to employees. On the other hand, Martin Sullivan, former CEO of AIG, approved $165 million and $121 million in bonuses to the Financial Products Group and execu-tives and other employees, respectively. Sullivan was ousted before the company took $200 billion in government bailout money, which was funded by U.S. taxpayers.50

Even the hint of wrongdoing can affect a company’s rela-tions with investors. Moreover, many investors simply do not want to invest in companies that engage in certain business practices, such as the use of sweatshops or child labor, which fail to provide employees with adequate working conditions. It is therefore critical that companies understand the issues of this very important group of stakeholders and what they expect from corporations in which they have invested, both financially and socially.

“Even the hint of wrong doing can affect a company’s relations with investors.”





Organizations can obtain feedback from stakeholders through standardized surveys, interviews, and focus groups. Companies can also encourage stakeholder exchanges by in-viting specific groups together for discussions. Such meetings also may include an office or facility tour or a field trip by company representatives to sites in the community. Regard-less of how companies collect information about stakeholders’ views, the primary objective is to generate a variety of opinions about how the company is perceived and whether it is fulfilling stakeholders’ expectations.51

Once this information has been collected, the firm should compare its internal per-ceptions to those discovered during the stakeholder assessment stage and summarize its findings. During this phase, the audit committee should draw some conclusions about the information it obtained in the previous stages. These conclusions may involve descriptive assessments of the findings, such as the costs and benefits of the company’s ethics program, the strengths and weaknesses of the firm’s policies and practices, the nature of feedback from stakeholders, and issues that should be addressed in future audits. In some cases, it may be appropriate to see how the findings fit with standards identified earlier, both quan-titatively and qualitatively.52

Data analysis should also include an examination of how other organizations in the indus-try are performing in the designated subject areas. For example, the audit committee can in-vestigate the successes of some other benchmark firm that is considered the best in a particular area and compare the auditing company’s performance to it. Some common examples of the benchmark information available from most corporate ethics audits are employee or customer satisfaction, how community groups perceive the company, and the impact of the company’s philanthropy. For example, the Ethics and Compliance Officer Association (ECOA) conducts research on legal and ethical issues in the workplace. These studies allow ECOA members to compare their responses to the aggregate results obtained through the study.53 Such compari-sons can help the audit committee identify best practices for a particular industry or establish a baseline for minimum ethics requirements. It is important to note that a wide variety of stan-dards are emerging that apply to ethics accountability. The aim of these standards is to create a tool for benchmarking and a framework for businesses to follow.

Verify the ResultsThe next step is to have an independent party—such as a social/ethics audit consultant, a financial accounting firm that offers social auditing services (such as KPMG), or a non-profit special interest group with auditing experience (for example, the New Economics Foundation)—verify the results of the data analysis. Business for Social Responsibility, a nonprofit organization supporting social responsibility initiatives and reporting, has defined verification as an independent assessment of the quality, accuracy, and completeness of a company’s social report. Independent verification offers a company, its stakeholders, and the general public a measure of assurance that the company has reported its ethical performance fairly and honestly, as well as providing an assessment of the company’s social and environ-mental reporting systems.54 It also lends an audit report credibility and objectivity.55 Siemens AG in Munich, for example, had its sustainability report verified by the accounting firm PricewaterhouseCoopers.56 However, a survey conducted by one of the Big Four accounting firms found that only a few social reports contained any form of external verification.

This lack of third-party assurance may have contributed to the criticism that social and ethics auditing and reporting have more to do with public relations than genuine





change. But though the independent validation of ethics audits is not required, the number of independently verified reports is increasing.57 Many public policy experts believe that an independent, objective audit can be provided only if the auditor has played no role in the reporting process—in other words, consulting and auditing should be distinctly separate roles. The Sarbanes–Oxley Act essentially legalized this belief.

Verification of the results of an audit should involve standard procedures that control the reliability and validity of the information. As with a financial audit, auditors can apply substantive tests to detect material misstatements in the audit data and analysis. The tests commonly used in financial audits—confirmation, observation, tracing, vouching, analyti-cal procedures, inquiry, and recomputing—can be used in ethics and social audits as well. For example, positive confirmations can be requested from the participants of a stakeholder focus group to verify that the reported results are consistent with the results the focus group believed it found. Likewise, an ethics auditor can observe a company’s procedures for han-dling ethical disputes to verify statements made in the report. And just as a financial auditor follows supporting documents to financial statements to test their completeness, an ethics auditor or verifier may examine employee complaints about an ethics issue to check whether the reporting of such complaints was complete. An auditor can also employ analytical pro-cedures by examining plausible relationships such as the prior year’s employee turnover ra-tio or the average turnover rate commonly reported within the industry. With the reporting firm’s permission, an auditor can contact the company’s legal counsel to inquire about pend-ing litigation that may shed light on ethical and legal issues currently facing the firm.58

Additionally, a financial auditor may be asked to provide a letter to the company’s board of directors and senior managers to highlight inconsistencies in the reporting pro-cess. The auditor may request that management reply to particular points in the letter to indicate the actions it intends to take to address problems or weaknesses. The financial au-ditor is required to report to the board of directors’ financial audit committee (or equiva-lent) any significant adjustments or difficulties encountered during the audit as well as any disagreements with management. Therefore, ethics auditors should be required to report to the board of directors’ audit committee the same issues that a financial auditor would report.59 Green Mountain Coffee uses this method.

Report the FindingsThe final step in our framework is issuing the ethics audit report. This involves reporting the audit findings through a formal report to the relevant internal parties, namely, the board of directors and top executives, and, if approved, to external stakeholders. Although some companies prefer not to release the results of their audits to the public, more companies are choosing to make their reports available to a broad group of stakeholders. Some companies, including the U.K.-based Co-operative Bank and the British newspaper The Guardian, in-tegrate the results of their social audits with their annual financial reports and other impor-tant information. Many other companies, including Johnson and Johnson, Shell, and Green Mountain Coffee, also make their audit reports available on their corporate websites.60

Based on the guidelines established by the Global Reporting Initiative and Accountability, the report should spell out the purpose and scope of the audit, the methods used in the audit process (evidence gathering and evaluation), the role of the (preferably independent) auditor, any auditing guidelines followed by the auditor, and any report-ing guidelines followed by the company.61 The ethics audit of Johannesburg’s Chris Hani Baragwanath Hospital followed these guidelines.62 The report is more meaningful if it is





integrated with other organizational information available, such as financial reports, employee sur-veys, regulatory filings, and customer feedback. The firm might also want to include in its ethics audit a section on best industry practices and how the firm compares to other companies in its field. Such a comparison can help a firm to identify its weaknesses and develop suggestions for improve-ment. The use of information such as the OCEG Benchmarking Study pinpoints key elements of corporate and ethics programs that could help assess best practices across the industry.63

As mentioned earlier, ethics audits may resemble financial audits, but they take quite different forms. In a financial audit, the State-ment of Auditing Standards dictates literally every word found in a financial audit report in terms of content and placement. Based on the auditor’s findings, the report issued can take one of the following four forms, among other variations. An unqualified opinion states that the financial statements are fairly stated. A qualified opinion asserts that although the auditor believes the financial statements are fairly stated, an unqualified opinion is not possible either because of limitations placed on the auditor or because of minor issues in-volving disclosure or accounting principles. An adverse opinion states that the financial statements are not fairly stated. Finally, a dis-claimer of opinion states that the auditor did not have full access to records or discovered a conflict of interest. These different opin-ions each have enormous consequences for companies.

THE STRATEGIC IMPORTANCE OF ETHICS AUDITING

Although the concept of auditing implies an official examination of ethical performance, many organizations audit their performance informally. Any attempt to verify outcomes and com-pare them with standards can be considered an auditing activity. Many smaller firms probably would not use the word audit, but they do perform auditing activities. Organizations such as the Better Business Bureau (BBB) provide awards and assessment tools to help any organiza-tion evaluate its ethical performance. Companies with fewer resources may wish to use the judging criteria from the BBB’s Torch Award Criteria for Ethical Companies (Table 9.7) as

Which Ethics Audit Process Works Better for Smaller Companies?

ABC Specialty Marketing, Inc., is considering a

formal ethics audit. The company has about

200 employees, including 50 salespeople that

sell promotional printing products. Recent ethical

issues have raised concerns within the company,

causing the last board of directors to think about

implementing a formal ethics audit. During the

meeting, one of the board members who had

examined the auditing process represented in

Table 9.5 indicated that for a small company, this

approach looked too formal. He felt that the Better

Business Bureau Torch Award Criteria for ethical

companies was a more practical approach to

auditing ethical risks and conduct. Another member

pointed out that the BBB criteria were more for

judging than for understanding the risk areas and

ethics program implementation concerns. This led

to a discussion about how to implement an ethics

audit in such a small company with a fairly limited

ethics program. The meeting ended without a clear

decision on which approach to use.

1. The Better Business Bureau Torch Award Criteria

is the best method for conducting a formal ethics

audit in a smaller company.

2. The auditing process represented in Table 9.5

offers a better way to understand a small

company’s ethical risks and conduct.

DEBATE ISSUE TAKE A STAND

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TABLE 9.7 Better Business Bureau’s Torch Award Criteria for Ethical Companies

A business should demonstrate its superior commitment to exceptional standards that benefit

its customers, employees, suppliers, shareholders and surrounding communities. The business

must provide supporting documentation in four areas for consideration in the Marketplace

Excellence category. While examples from all four areas must be provided, the bullet points

below are only suggestions and not all bullet points are required to be addressed in order

for a business to compete in this category.

Management PracticesNote: Owners of companies with no employees must explain how a personal commitment to

exceptional standards is applied in business practices.

(formal or informal) showing how the business’s commitment to exceptional standards are

communicated to and implemented by employees

exceptional standards that benefit its customers, employees, suppliers, shareholders and

surrounding communities

in dealing with ethical issues

(i.e., customer service program, employee relation policy or practice, vendor/supplier

relationship, etc.)

Community/Investor/Stakeholder Relations

how the business’s beliefs have been leveraged for the benefit of consumers, employees,

suppliers, shareholders, and surrounding communities

communities, investors and other stakeholder audiences

that had negative short-term consequences, but created long-term value and benefits

impact—and any recognition for charitable and/or community service projects.





benchmarks for their informal self-audits. Recent winners of this award included Amazon.com, Verizon, and Villa Springfield Health & Rehabilitation Center.64 The award criteria even provide a category for companies with less than 10 employees.

An ethics audit, like a financial audit, should be conducted regularly rather than in response to problems or questions about a firm’s priorities and conduct. In other words, the ethics audit is not a control process to be used during a crisis, although it can pinpoint potential problem areas and generate solutions in a crisis situation. As mentioned earlier, an audit may be comprehensive and encompass all the ethics and social responsibility areas of a business, or it can be specific and focus on one or two areas. One specialized audit could be an environmental impact audit in which specific environmental issues, such as proper waste disposal, are analyzed. According to the KPMG International Survey of Corporate Responsibility Reporting, 80 percent of the 2,200 companies in 22 countries surveyed in-clude CSR in their reporting, up from 50 percent in 2005.65 Examples of other special-ized audits include diversity, employee benefits, and conflicts of interest. Ethics audits can present several problems. They can be expensive and time consuming, and selecting the auditors may be difficult if objective, qualified personnel are not available. Employees sometimes fear comprehensive evaluations, especially by outsiders, and in such cases eth-ics audits can be extremely disruptive.

Despite these problems, however, auditing ethical performance can generate many benefits, as we have seen throughout this chapter. The ethics audit provides an assessment of a company’s overall ethical performance as compared to its core values, ethics policy, internal operating practices, management systems, and most importantly, key stakeholder expectations.66 As such, ethics and social audit reports are a useful management tool for helping companies identify and define their impacts and facilitate important improve-ments.67 This assessment can be used to reallocate resources and activities as well as to

Communications and Marketing Practices

advertisements are truthful and accurate

transactions are made in a transparent, honest manner

prevented negative outcomes and restored trust and confidence in the business, its products

and services

overall business effectiveness and efficiency

Industry Reputation

business

group or community

Source: “International Torch Award Judging Criteria,” Better Business Bureau, http://www.bbb.org/international-torch-awards/critera.html

(accessed March 23, 2011).





focus on new opportunities. The audit process can also help companies fulfill their mis-sion statements in ways that boost profits and reduce risks.68 More specifically, a company may seek continual improvement in its employment practices, its customer and commu-nity relations, and the ethical soundness of its general business practices.69 An audit can pinpoint areas where improving operating practices can improve bottom-line profits and stakeholder relationships.70

Most managers view profitability and ethics and social responsibility as a trade-off. This “either/or” mindset prevents them from taking a more proactive “both/and” approach.71 But the auditing process can demonstrate the positive impact of ethical conduct and social responsibility initiatives on the firm’s bottom line, convincing managers—and other primary stakeholders—of the value of adopting more ethical and socially responsible business practices.72

SUMMARY

Viewing a business ethics program as a part of strategic planning and management ac-tivities is critical to the success of any firm. However, for such programs to be success-ful, firms must put controls and systems in place to ensure that they are being executed effectively. Controls include input, output, and process controls. Input controls are con-cerned with providing necessary tools and resources to the organization, such as good employees and effective ethics training and structural systems. Process controls include managerial commitment to an ethics program and to the methods or system for the evaluation of ethics. Output controls involve comparing standards with actual behavior. One of the most popular methods of evaluating ethical performance is an ethics audit.

An ethics audit is a systematic evaluation of an organization’s ethics program and/or its ethical performance. Such audits provide an opportunity to measure conformity with the firm’s desired ethical standards. The concept of ethics auditing has emerged from the movement toward auditing and reporting on companies’ broader social responsibility initiatives. Social auditing is the process of assessing and reporting a business’s perfor-mance in fulfilling the economic, legal, ethical, and philanthropic social responsibilities expected of it by its stakeholders. An ethics audit may be conducted as a component of a social audit. Auditing is a tool that companies can use to identify and measure their ethical commitment to stakeholders and to demonstrate their commitment to improving strategic planning, including their compliance with legal, ethical, and social responsibil-ity standards.

The auditing process can highlight trends, improve organizational learning, and facilitate communication and working relationships. It can help companies assess the effectiveness of their programs and policies, identify potential risks and liabilities, im-prove compliance with the law, and demonstrate progress in areas of previous noncompli-ance. One of the greatest benefits of these audits for businesses is improved relationships with stakeholders. Ethics auditing may help prevent public relations crises associated with ethical or legal misconduct. Although ethics audits provide many benefits for com-panies and their stakeholders, they do have the potential to expose risks; the process of auditing cannot guarantee that a firm will not face challenges. Additionally, there are few common standards for judging disclosure and effectiveness or for making comparisons within an industry.





An ethics audit should be unique to each company based on its size, industry, corpo-rate culture and identified risks, and the regulatory environment in which it operates. This chapter has offered a framework for conducting an ethics audit that can also be used for a broader social audit.

The first step in conducting an audit is securing the commitment of the firm’s top management and/or its board of directors. The push for an ethics audit may come directly from the board of directors in response to specific stakeholder concerns or corporate gov-ernance reforms, or from top managers looking for ways to track and improve ethical per-formance. Whatever the source of the audit, its success hinges on the full support of top management.

The second step is establishing a committee or team to oversee the audit process. Ide-ally the board of directors’ financial audit committee would oversee the ethics audit, but in most firms, managers or ethics officers conduct auditing. This committee recruits an individual from within the firm or hires an outside consultant to coordinate the audit and report the results.

The third step is establishing the scope of the audit, which depends on the type of business, the risks faced by the firm, and available opportunities to manage ethics. This step includes defining the key subject matter or risk areas that are important to the ethics audit.

The fourth step is a review of the firm’s mission, values, goals, and policies. This step should include an examination of formal documents that make explicit commitments with regard to ethical, legal, or social responsibility, and less formal documents including marketing materials, workplace policies, and ethics policies and standards for suppliers or vendors. During this step, the firm should define its ethical priorities and articulate them as a set of parameters or performance indicators that can be objectively and quantitatively assessed.

The fifth step is identifying the tools or methods that can be used to measure the firm’s progress, and then collecting and analyzing the relevant information. Some evidence-collection techniques include examining internal and external documents, observing the data-collection process (such as discussions with stakeholders), and confirming the infor-mation in the organization’s accounting records. During this step, a company’s stakeholders need to be defined and then interviewed to understand how they perceive the company, for example through standardized surveys, interviews, and focus groups. Once this informa-tion has been collected, it should be analyzed and summarized. Analysis should include an examination of how other organizations in the industry are performing in the designated subject matter areas.

The sixth step is having an independent party—such as a social/ethics audit consul-tant, a financial accounting firm that offers social auditing services, or a nonprofit special interest group with auditing experience—verify the results of the data analysis. Verification is an independent assessment of the quality, accuracy, and completeness of a company’s audit process. Such verification gives stakeholders confidence in a company’s ethics audit and lends the audit report credibility and objectivity. The verification of the results of an audit should involve standard procedures that control the reliability and validity of the information.

The final step in the audit process is reporting the audit findings to the board of directors and top executives and, if approved, to external stakeholders. The report should spell out the purpose and scope of the audit, the methods used in the audit process (evidence gathering and evaluation), the role of the (preferably independent)





auditor, any auditing guidelines followed by the auditor, and any reporting guidelines followed by the company.

Although the concept of auditing implies an official examination of ethical perfor-mance, many organizations audit informally. Ethics audits should be conducted regu-larly. Although social auditing may present problems, it can also generate many benefits. Through the auditing process, a firm can demonstrate the positive impact of ethical con-duct and social responsibility initiatives on its bottom line, which may convince stakehold-ers of the value of adopting more ethical and socially responsible business practices.

IMPORTANT TERMS FOR REVIEWethics audit social audit





there was substantial remuneration for his time, which John affirmed. Jerry asked a few questions, such as whether Alan had sufficient managerial authority.

Alice responded, “Jerry, this industry is rather small. There are only a few large players, Soumey being one of them. Trust me when I say that Alan, as a retired president of the company, will defi-nitely have the respect of the employees.”

Jerry had no more questions, and Alan became Soumey’s new compliance officer. The confidential hotline was quickly installed, and announcements about its existence were widely distributed around the various offices and plant buildings to ensure that it reached each of the firm’s several thousand employees. The board also discussed TIW’s final suggestion for an ethics committee, and all but Jerry agreed that the board could handle that task as well.

Jerry pointed out, “I don’t think this is wise, John. This is a conflict of interest for you, isn’t it?”

After a moment of hesitation, John replied, “You’re right, Jerry, it is a conflict of interest for me to serve on the ethics committee.” After an-other bit of silence, John suggested, “Wouldn’t you agree that I should not be on the committee, Alan, Alice, and Latisha?” They all discussed the matter and agreed that Jerry’s suggestion made perfect sense.

Time passed, and the board held its quarterly meetings. Nothing unusual was brought up, just the same old issues that any publicly held company must deal with relative to shareholders, lawyers, regulators, and the public. Alan had suggested that the ethics compliance committee meet twice a year so that he could fill everyone in on what was hap-pening. At these meetings, Alan would usually re-port the number of calls to the hotline, the status of complaints, and whether there were any serious allegations such as sexual harassment or any re-ported forms of race, sex, or age discrimination in hiring personnel.

As Jerry looked around at the other members of the board, he wondered if it was too late to resign. How could he have been stupid enough to get dragged into this ethics audit quagmire? It had started innocently enough. With the passing of the Sarbanes–Oxley Act, everyone was aware of the consequences of accounting problems and their potential negative impact on a company, its board members, and its employees. So when Jer-ry’s friend John Jacobs, the president of Soumey Corp., asked him to be on the company’s board of directors, Jerry had checked out the company. It wasn’t that he didn’t trust John; he just felt that he should never take unnecessary chances. But when Jerry’s investigation of Soumey un-covered nothing unusual, he accepted the board position.

Besides Jerry and John, Soumey’s board of directors included Alan Kerns, a retired Soumey executive; Alice Finkelstein, a retired executive from a similar company; and Latisha Timme, a consultant within the industry. After Jerry joined the board, one of its first tasks was to conduct an ethics audit. The directors decided to contract the task to Teico, Inron, and Wurrel (TIW), an accounting firm highly recommended by Latisha. A few months later, TIW filed its final report of the audit with the board. The report indicated that, with a few exceptions, Soumey was doing a good job of monitoring ethical issues. Among the recommendations that the report offered were that the company should appoint a person with high managerial authority to be responsible for its ethical compliance program, that it establish a confidential hotline for employees who had ethical or legal concerns, and that it create an ethics committee to address ethical issues in the organization.

At the next board meeting, John suggested that Alan be the ethics compliance officer be-cause he lived close to the main offices and had time to do it. Alan quickly agreed, provided

RESOLVING ETHICAL BUSINESS CHALLENGES*





with no incentives. They lost 40 percent of what they’d been making with all the overtime and performance-based stuff. The guys and I agreed not to report it for those reasons.”

Jerry couldn’t help interrupting, “So why didn’t the company fix the problem after it hap-pened the first time?”

One of the men asked, “Are you new here?”“Yeah, been here only a few weeks,” Jerry lied.The production worker answered, “You want

to boost your pay, right? So you cut a few corners to get by.”

Later that evening, after Jerry and his family had returned home, Rosa told him about a con-versation she had overheard. “These women were talking about how unfair it is that most of the incentive-based pay seems to go to men with fami-lies. One woman said that she heard of a man over 55 who should have gotten a promotion, but who was turned down because his supervisor was told not to give it to him. Rumor was that this guy had bucked the last president of Soumey, and that was his payback. Jerry, you should have heard what they say about Alan—that he’s like Santa Claus and the Grinch. You never see him—and if you do, it’s not a pleasant experience. One woman told me that when she was working for him, he used to be a little too friendly. She said that’s why no one re-ally uses the ethics hotline for certain issues. They know that the fox is guarding the hen house.”

A little later, one of Jerry’s sons bounced into the room and asked him a question about the picnic. “Dad, how come all the Spanish-speaking workers are on the night shift? It really makes it hard for a couple of my friends to get their parents to drop them off for soccer.”

The picnic opened Jerry’s eyes to an uglier side of Soumey. At the next board meeting, he in-directly addressed some of the problems he had noticed. But John responded, “We’re going into a recession, and we have to cut a few corners to keep our dividends up to the market’s expectations. Latisha has been watching and consulting me on the best way to keep ahead of the pack on this.”

Latisha and Alice both commented, “Thank goodness we have a large Hispanic workforce to

After two years of quarterly board meetings and semiannual ethics meetings, Jerry suggested to Alan that they conduct another ethics audit.

“Why would we want to do that, Jerry? Things are going smoothly with the approach we’re tak-ing. Why have another outside audit? Do you think that we’re doing a bad job?”

Jerry hedged. “I’m not saying that, Alan. What I’m saying is that we may need to have an outside audit just to make sure everything looks good to the public. Why don’t we discuss this with Latisha and Alice this week?”

Alan agreed, but when the ethics committee met that week it was obvious to Jerry that Alan had spoken to Alice and Latisha about his and Jerry’s meeting. He wasn’t surprised when the committee decided that another audit would diminish confi-dence in Alan’s performance as ethics compliance officer. Several weeks later, John sent all the board members a letter announcing an increase in their pay as board directors as well as doubling their pay as ethics committee members. The letter stated, “Soumey Corp. has decided that your service to the company has been exemplary, both as board members and as an ethics committee.”

In Jerry’s third year on the board of direc-tors, he was finally able to attend Soumey’s annual company picnic with his wife and children. They arrived late, after all of the introductions, and everyone was already in the buffet line. As a result, no one really knew who he was. The children were having fun, and Jerry and his wife, Rosa, were too. However, after a while Jerry began to overhear some interesting comments. In one conversation, a production worker spoke about a toxic spill that had occurred because of the lack of safeguards. He told his companion, “Yeah, I know it was pretty messy, but only a few of my crew were hurt.”

His friend asked, “Did they or you report it to management?”

He exclaimed, “Are you kidding? My guys don’t want to lose their bonuses. Remember what happened to Bob’s crew when the same thing hap-pened and some of his guys complained? They had them filling out paperwork for a whole day, and the next week they were assigned a project





offset some price increases. They’re hard workers and don’t complain.”

“You’re absolutely right,” said Alan. “We don’t have the EPA, OSHA, or other agencies on our backs because these people know how to work and keep quiet. If some federal agencies do start to poke around, I have some contingency plans to prevent any type of ethical disaster.”

That evening Jerry and Rosa were talking about the situation. He told Rosa, “I think Soumey has some potentially ethical issues that need to be addressed—but what can I do?”

“Well,” sighed Rosa, “We’ve lived in this town for a long time. We know the families that are on the board. They’re good people. However, there’s one thing you didn’t hear at that picnic because of your lack of Spanish. I’ve told you that it’s impor-tant to learn it, even if it’s just for my family. A few of the people I overheard were talking about how the hotline isn’t really anonymous. That’s just not right, Jerry. You need to do something even if it

does mean losing the extra income.” Rosa’s points struck a nerve because Jerry knew they were a little overextended financially.

“I’ll see what I can do,” he told her.Still, she warned him, “That’s good, honey,

but remember I don’t want you to make too many waves. We still have to live here, and you know we can’t swing a dead cat and not hit one of the people at Soumey.”

QUESTIONS | EXERCISES

1. What areas of its ethics audit should Soumey change?

2. Does Jerry have a duty to report any of the items that he has heard to an outside authority?

3. Is Jerry responsible for the problems associated with Soumey over the last three years? Explain why or why not.

*This case is strictly hypothetical; any resemblance to real per-sons, companies, or situations is coincidental.

CHECK YOUR EQ

Check your EQ, or Ethics Quotient, by completing the following. Assess your performance to evaluate your

overall understanding of the chapter material.

1. Ethics audits are required by the Sarbanes–Oxley Act of 2002. Yes No

2. In public corporations, the results of ethics audits should be reported to the

board of directors.

Yes No

3. An ethics audit helps identify risks and rogue employees. Yes No

4. The scope of an ethics audit depends on the type of risks and the

opportunities to manage them.

Yes No

5. Smaller companies can skip the step of verifying the results of an ethics audit. Yes No

ANSWERS 1. No2. Yes. This is consistent

with good corporate governance but not required. 3. Yes. This is the main benefit of an ethics audit. 4. Yes. The scope

determines the risks unique to the organization. 5. No. Verification is necessary to maintain integrity and accuracy.




Case 19: Nike: Managing Ethical Missteps 495

CASE 19

Nike: Managing Ethical Missteps—Sweatshops to Leadership in

Employment Practices*

Phil Knight and his University of Oregon track coach Bill Bowerman founded Blue Ribbon Sports, later renamed Nike, in 1964. The idea, born as a result of a paper written by Knight during his Stanford MBA program, was to import athletic shoes from Japan into the U.S. market, which was otherwise dominated by German competitors Puma and Adidas. The company began as a distributor for a Japanese athletic shoe company, Onitsuka Tiger, but also developed its own brand of athletic footwear to promote in the American market. The company’s relationship with Onitsuka Tiger ended in 1971, and the Nike brand was created in 1972 (named “Nike” after the Greek goddess of victory). The company as a whole was renamed Nike in 1978, and has since grown to be the largest worldwide seller of athletic goods, with approximately 168 Nike stores in the United States and a presence in about 160 countries.

Nike was publicized by celebrity athlete sponsors. As the popularity of the Nike prod-uct grew, so did the company’s manufacturing demands. In contrast to its meteoric rise in the 1980s after going public, the late 1990s began a period of combating allegations about labor and human rights violations in Third World countries in which manufacturing had been subcontracted. Nike’s response to this issue has been considered by critics to be more focused on damage control than on a sincere attempt at labor reform.

CRITICISMS OF NIKE’S MANUFACTURING PRACTICES

In order to remain competitive and keep manufacturing costs low, athletic footwear pro-duction has moved to areas of the world with low labor costs. Assembly of shoes (as well as low-cost apparel, footwear, radios, TVs, toys, sporting goods equipment, and consumer electronics) began shifting offshore in the 1960s, first to Japan, then to Korea and Taiwan, and then, beginning in the 1980s, to Southern China. By the mid-1980s Taiwan and Korea supplied 45 percent of the world’s footwear exports, and production has continually shifted to other Asian nations where the cost of manufacturing is lower still.

Because of its history and experience with Japanese manufacturing and produc-tion, Nike was a pioneer in overseas manufacturing as a way to cut costs on sports gear

*This case was prepared by O. C. Ferrell, Jennifer Jackson, and Jennifer Sawayda. Melanie Drever and Alexi Sherrill assisted on the previous edition. This case was prepared for classroom discussion rather than to illustrate either effective or ineffective handling of an administrative, ethical, or legal decision by management. All sources used for this case were obtained through publicly available material.




496 Part 5: Cases

manufacturing. When Japan became too expensive, Nike shifted its contracts to Vietnam, Indonesia, and China. The working conditions in these factories have been a source of controversy. Allegations of poor conditions, child labor, widespread harassment, and abuse have all been issues for the company. Because the Asian factories have further subcon-tracted out the work, it has become increasingly difficult for Nike to keep track of and regulate the working conditions and wages in these factories.

Sweatshop labor is not merely an issue for Nike. It permeates the public conscious-ness across all manufacturing. Perhaps the incident that brought sweatshop labor to the forefront of American consciousness was the Kathy Lee Gifford debacle in 1996 when the human rights group the National Labor Committee uncovered that Gifford’s clothing line was made in Honduran sweatshops that used child labor. As an industry leader, Nike’s high visibility made it ripe for attack when labor rights violations were uncovered.

Since the mid-1990s, Nike has faced a barrage of criticism from labor rights activists, the mainstream media, and others for human and labor rights violations in its factories. The accusations have included deficiencies in health and safety conditions, extremely low wages, and indiscriminate hiring and firing practices. While much of the firestorm has died down as Nike and other athletic wear manufacturers have sought to clean up their images, the criticism has damaged the company’s reputation.

In Indonesia, where Korean suppliers owned a majority of Nike factories, reports by labor activists and other nongovernmental organizations revealed several cases of human rights abuses and labor violations. These conditions came to the attention of the general public through stories such as Roberta Baskin’s CBS report on the conditions in Nike’s manufacturing facilities in Indonesia in 1993.

In 1996 Life magazine published an exposé complete with photos of Pakistani children stitching soccer balls for Nike, Adidas AG, and other companies. The images of these chil-dren had a devastating impact on Nike’s sales and corporate reputation. Customers who had previously held the American athletics brand in high regard began to develop a lower opin-ion of the company. Bob Herbert’s op-ed article in The New York Times in 1996 led to further public interest in this issue, and protests and demonstrations were held all over the United States. Several demonstrations occurred at “Nike Towns,” the Nike retail megastores.

Nike also experienced problems with factory conditions in Vietnam. A private report on one of its factories commissioned by Nike as part of an audit by Ernst and Young was leaked to the press, and The New York Times ran it as a front-page article. The audit reported unac-ceptable levels of exposure to chemicals in the factory and documented cases of resulting employee health problems, as well as other infringements of the established code of conduct.

In response to the criticisms raised during the 1990s, Nike had to take rapid measures not only to redeem its reputation, but also to rectify problematic policies and lack of inter-national oversight of its operations. Nike’s new priorities became to make certain that its factories were not taking advantage of its workers and to ensure that each worker had a safe work environment and competitive wage.

ENVIRONMENTAL PROBLEMS RELATED TO THE TEXTILE INDUSTRY

Because of the nature of the textile industry, Nike faces numerous challenges and poten-tially critical problems. The textile industry negatively impacts the environment wherever manufacturing is located. Problems generated by the textile industry in general, and Nike





specifically, include increased water deficits; climate change; pollution of land, air, and waterways; and large fossil fuel and raw material consumption. In addition to these envi-ronmental hazards, today’s electronic textile plants expend significant amounts of energy. All of these issues are exacerbated by Western culture, where fashions are popular for only a few months before being discarded.

In addition to environmental considerations, textile manufacturers must consider their employees’ working conditions. The demand for cheap labor and lax labor laws in developing countries such as Vietnam, China, and Indonesia have led to an increased prevalence of child labor and abusive practices. In her book No Logo, Naomi Klein claims that Nike abandons manufacturing sites when countries begin to work toward developing better pay and employ-ment rights. Nike’s critics believe the company should improve transparency measures in its factories, allow independent inspection to verify conditions, and disclose all audits to the pub-lic. Nike has complied with these demands to a limited extent. For example, audits of Nike generally have determined that Nike pays wages above the legal minimum. Critics are not sat-isfied, however, arguing that in most cases the wages still do not constitute a fair living wage.

In response, Nike claimed that sharing factory locations with independent third parties on a confidential basis enables the company to monitor its supply chain properly. It stated that disclosure of the factory names, plus details of audits of those factories, would be used by NGOs simply to make further attacks rather than as a way to help the company address and resolve problems. Nike also stated that establishing what constitutes a “fair” wage is difficult given the fact that costs of living and economic conditions vary from country to country.

NIKE RESPONDS TO CHALLENGES

Public protests against Nike have taken the form of boycotts and picketing of Nike stores. Universities have cancelled their deals with Nike to produce branded athletic goods. In 1998 Nike revenues and stock prices decreased by approximately 50 percent, and the com-pany laid off 1,600 workers. Nike launched a large public relations campaign to combat the damaging allegations of child labor, inhospitable working conditions, and low or nonex-istent wages. In an effort to directly address the concerns of student activists, Nike visited several college campuses, opening dialogue with students and university administrations about its manufacturing policies. Nike even invited teams of Dartmouth graduate students to tour the Indonesian and Vietnamese factories for three weeks at Nike’s expense.

The company has spent considerable resources focusing on improving the labor stan-dards in each of its factories. It must weigh the expense of labor in nations where product manufacturing is available. However, because these factories subcontract out to the local workforce, it is difficult for Nike to regulate the working environment. Nike must take extra measures to ensure that the independent subcontractors used to supply the work-force in their factories do not engage in any illegal activities such as child labor, excessive work hours, hostile work environments, or inappropriate payments.

Nike also has implemented a code of conduct for all of its suppliers, and has been working with the Global Alliance to help review its factories. In August 1996 Nike Corporation joined the Apparel Industry Partnership, a coalition of companies and labor and human rights groups assembled by the Clinton administration, to draft an industry-wide code of conduct.

Since universities form a core segment of Nike’s market and the company felt the reper-cussions of its manufacturing practices in the form of several canceled university contracts,




498 Part 5: Cases

Nike sent letters detailing the acceptable conditions in its factories and stressing its com-mitment to corporate responsibility to universities around the country. Representatives from Nike also visited campuses and spoke to students, assuring them of Nike’s intention to be a responsible corporate citizen. Phil Knight himself visited the campus of the Univer-sity of North Carolina at Chapel Hill. Nike also launched a public relations campaign that included writing op-ed pieces, letters to the editor, and press releases to defend its reputa-tion and to refute critics’ claims.

However, Marc Kasky, a California activist, maintained that Nike’s claims were mis-leading and deceptive to the public. He filed a lawsuit claiming that Nike’s actions should be classified as commercial speech that violated California’s unfair competition and adver-tising laws. The legal controversy culminated in the California Supreme Court’s decision in Kasky v. Nike. The court determined that public relations communications may constitute “commercial speech” that can be interpreted as “false advertising.” As commercial speech is afforded less protection under the First Amendment, Nike would be liable for any claims under its public relations campaign that could be construed as misleading the public. After the ruling, Nike settled the lawsuit at approximately $2 million.

NIKE’S CORPORATE SOCIAL RESPONSIBILITY

Nike’s corporate social responsibility (CSR) practices have been evolving since 1991. At first, Nike’s approach to CSR could be characterized as insufficient and generally lacking in any true forms of regulation and implementation throughout its global supply chain. Manufacturers in foreign locations were simply trying to comply with the minimal contract requirements, while at times overlooking fair labor practices in order to per-form as low-cost suppliers. Nike’s initial response to criticism was reputation management rather than wide-scale changes in its practices. However, as more and more issues have surfaced and been brought to the attention of both the corporation and

its consumers, Nike has increased its efforts to be more ethical in its manufacturing prac-tices and has become something of an industry leader in certain areas.

According to Harvard University senior fellow Simon Zadek, corporate responsibility evolves through five stages:

1. Defensive: “It’s not our fault.”2. Compliance: “We’ll do only what we have to.”3. Managerial: “It’s the business.”4. Strategic: “It gives us a competitive edge.”5. Civil: “We need to make sure everybody does it.”

Nike could be classified as having evolved from the defensive stage through the compli-ance stage to the managerial stage. The company’s first CSR report demonstrated how Nike had handled complaints from stakeholders who wanted to see better working condi-tions at Nike’s contract factories. In its 2005 report, the company provided the names and locations of factories that produced its products for the first time ever. In its third CSR

“Nike has increased its efforts to be more ethical in its manufacturing practices and has become something of an industry leader in certain areas.”





report, Nike officials said they were moving away from using corporate responsibility as a crisis-management tool and would instead be using it as an opportunity for innovation and growth.

Nike must now grow fully into the fourth and fifth CSR stages. The company must continue to develop its corporate responsibility strategies and increase enforcement of its policies in its factories to ensure its market share dominance in the footwear industry. With its new emphasis on corporate responsibility as an innovative tool, Nike is implementing further CSR initiatives to make the company an industry leader and thus give it a competi-tive edge in the footwear industry.

The following sections further discuss some of Nike’s CSR practices. The areas covered include environmental sustainability, audit tools used to evaluate Nike contractor practices, factory transparency, Nike’s corporate responsibility committee, and philanthropy.

Environmental SustainabilityIn 1990 Nike began development of the Reuse-A-Shoe Program to reduce the company’s environmental footprint (so to speak) and decrease the amount of shoes that end up in landfills. The purpose of the program was to find an environmentally friendly way to dispose of worn-out shoes. The material made from the recycled shoes was called “Nike Grind.” In 1995 Reuse-A-Shoe began collecting old shoes in Nike retail stores. In 2002 Nike expanded Reuse-A-Shoe by partnering with the National Recycling Coalition and by beginning plans to go international with drop-off stations in Europe and Australia. Since the program was created, more than 1.5 million pairs of used shoes have been collected for recycling each year. Nike has collected more than 25 million pairs of used athletic shoes since 1995.

Nike has also crafted a sustainability philosophy called Considered Design in its step toward creating a closed-loop business. A closed-loop business occurs when waste at all levels of the operation can be recycled. According to Nike, Considered Design is “a com-panywide ethos built around designing the best products for the best athletes while using the most sustainable methods possible.” To make Considered Design a reality, Nike has set forth a variety of baseline standards that its products must meet or exceed. Its goal is to have all of its products from all over the world meet these standards by 2020.

Audit ToolsIn 1998 Nike developed auditing tools to help provide increasing transparency and insight into the manner in which Nike contract factories are evaluated for compliance with com-pany standards. Management Audit Verification (MAV) combines audit and verification into one tool. It helps to identify issues related to work hours, wages and benefits, freedom of association, and grievance systems, as well as to follow up on these issues and to create an action plan to correct them according to local law and Nike’s Code Leadership Stan-dards. The Environment, Safety and Health (ESH) audit is an in-depth audit tool used by Nike compliance teams to determine compliance with Nike’s Code Leadership Standards. In addition to its own auditing tools, external organizations such as NGOs frequently audit Nike. Until recently, Nike also employed a Safety, Health, Attitude of Management, People and Environment (SHAPE) tool used quarterly by contract factories to determine their compliance with Nike’s Code Leadership Standards. In 2007 the tool was changed to a




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factory self-evaluation as Nike felt that a numeric score by itself was insufficient. Nike esti-mates that it visits its factories an average of 1.77 times per year.

Factory TransparencyIn 2000 Nike became the first company to respond to student requests to publicly disclose the names and locations of its con-tracted factories that produced licensed collegiate products. A contract factory making Nike products could be producing for as many as thirty different schools. By disclosing its supply chain, Nike believes it can be more successful at monitoring and making changes once issues have been uncovered not only in its own factories, but also on an industry-wide basis. The company hopes that by disclosing its own supply chain, it can encourage other companies to do the same. The company also feels that transparency should work as a motivator for contract factories. Those with high compliance rankings can be confi-dent that business will come their way.

With multiple brands, and many universities represented, contract factories must decide which company’s code(s) of conduct to follow. This task is not an easy one, as standards for the varying corporate codes of conduct can contradict each other. Nike has attempted to make it easier for contract factories to comply with its code of conduct by guaranteeing that its code aligns with that of the Fair Labor Association. The company hopes that eventually a standardized code of conduct followed by all companies in the industry can be implemented, creating widespread compliance and better working con-ditions. Even as Nike has taken dramatic steps to increase its transparency and account-ability, activists have continued to put pressure on the company to improve its standards and practices.

Nike also has implemented a program it calls the Balanced Scorecard for its suppliers. The Balanced Scorecard is a lettered grading system used to better assess factory compli-ance with the code of conduct. Rather than simply assessing financial factors, the Balanced Scorecard also measures labor, health, and environmental standards of factories. This sys-tem gives the company a reliable method for rewarding high-performance, compliant facto-ries. The card measures cost, delivery, and quality, all of which need to be addressed equally for the work in factories to flow smoothly. The Balanced Scorecard gives factories incentives to improve working conditions, and Nike rewards those that show improvement.

Corporate Responsibility CommitteeIn order to become a leader in corporate responsibility, Nike established a Corporate Responsibility (CR) Committee to review policies and activities and to make recommen-dations to the board of directors regarding labor and environmental practices, community affairs, philanthropy, diversity and equal opportunity, and environmental and sustainability initiatives. The board is actively involved on the committee; at least two committee mem-bers must be from the board of directors. Nike expects corporate responsibility to be inte-grated into the executive level as well. Nike’s Vice President of Corporate Responsibility, for example, reports directly to the CEO of Nike. These leaders help to ensure that corporate responsibility is considered at every level of the company.

“Nike became the first company to respond to student requests to publicly disclose the names and locations of its contracted factories that produced licensed collegiate products.”





PhilanthropyOne of Nike’s newest goals to increase its CSR is by building a social network “where innova-tions are shared, new funds are mobilized and human and social capital is exchanged in sup-port of a global movement based on the power of sport to unleash human potential.” Nike’s goal is to encourage the use of sports as a means of empowering individuals and building skills such as leadership, conflict resolution, equity, and trauma relief. Nike partners with various groups that work with low-income youth, minorities, and young women who live in conflict situations across the world. Because sports require access to safe spaces, good coaches, safe equipment, and education, Nike is forming partnerships in these areas. The company awarded $315 million in grants, product donations, and other support through 2011 to give underprivi-leged youth greater access to sport programs. While contributing to the global community, the company also strives to invest in its own local communities of Portland, Oregon; Memphis, Tennessee; Hilversum, Holland; Laakdal, Belgium; and other places around the world where Nike corporate offices are located. With a continued focus on corporate responsibility, Nike strives to build and improve its relationships with consumers, to achieve a high-quality supply chain, and to create top-quality, innovative products.

NEW CHALLENGES IN THE FUTURE

So far Nike’s efforts have seemed to pay off, as it has seen considerable improvement in its reputation and corporate image in the past few years. As a result of its positive changes, Nike appeared in Fortune’s 2010 list of “The World’s Most Admired Companies” as the number one most admired apparel company and was ranked 24 overall. Nike was also listed at num-ber 23 in CR (Corporate Responsibility) magazine’s “Best Corporate Citizens” in 2010.

The news has not all been good for Nike, however. In 2010 several universities threat-ened to cancel their contracts with Nike over labor concerns among Honduran factory workers. A year earlier, two of Nike’s subcontractors had closed without notice, laying off 1,800 workers. Under Honduran labor law, the workers were owed over $2 million in sever-ance pay along with other unemployment aid. Although Nike agreed to provide the workers with training and give them priority jobs at other factories, the company stated that the re-sponsibility for the situation rested with the suppliers, not Nike. One could argue that Nike was reverting back to the defensive stage of corporate responsibility. Nike’s actions did not go far enough to please the Worker Rights Consortium, who began urging universities to cancel their contracts with Nike until the labor dispute was settled. Other labor watchdogs staged demonstrations outside Nike shops, changing Nike’s slogan from “Just Do It” to “Just Pay It.” The University of Wisconsin–Madison was the first to cancel its licensing agreement with Nike, stating that its code of conduct requires companies that make products carrying the university name to assume responsibility for their suppliers. Nike eventually capitulated and set aside a $1.54 million fund to aid the laid-off Honduran workers. Although Nike ex-perienced bad publicity over the event, labor activists see its actions as a positive deviation from industry standards. They hope that this step will set a precedent for other companies to follow.

This incident reveals that there are still flaws in Nike’s supply chain, both in contract negotiation and supplier oversight. Although some experts herald Nike as a leader in CSR, its use of hundreds of international contractors makes detection and enforcement of abuses incredibly difficult. Nike plans to pursue an accelerated growth strategy in foreign markets,




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particularly in emerging economies, which makes increased oversight of its factories even more of an imperative.

Indeed, Nike sees international expansion as essential for its continued profitability. About one-fourth of Nike’s sales come from developing countries. China in particular represents a lucrative market for Nike, with profit margins of 37 percent compared to 23 percent in North America. As a result of this high growth potential, Nike has announced plans to increase its sales in emerging economies from $3 billion to $3.5 billion by 2015. Nike is also taking steps to portray itself as a socially responsible company and increase its visibility; during the 2010 World Cup, for example, Nike opened a facility in a low-income South African township that doubled as both a football training center and a clinic for AIDS testing and awareness.

Corporate and social responsibility are not only changing Nike’s image; they can also be good for its bottom line in a highly competitive industry. Nike’s target audience has broadened from mainly male athletes to female athletes and children as well. As Nike’s target audience widens, being perceived as an ethical company will help attract and retain new customers.

Such an approach is requiring Nike to undertake socially responsible initiatives and develop more sustainable products. For instance, Nike celebrated the World Cup while simultaneously embracing sustainability with a new product: World Cup shirts made from recycled bottles. According to Nike, each shirt requires less material and consists of recycled polyester and eight recycled bottles. It is estimated that Nike’s recycled shirts kept over 550,000 pounds of polyester out of landfills. Nike is also creating innovative products to increase consumers’ healthy living (as well as the bottom line). Its Nike+ shoes contain sensors that can communicate with the wearer’s iPod to track the person’s consumption of calories. Nike plans to develop more innovative and sustainable products in the future.

Nike itself admits that it has a long way to go in the area of corporate responsibility, including continuing to improve its monitoring systems. However, the company is being rewarded for its efforts toward improvement thus far.

QUESTIONS

1. Why did Nike fail to address corporate social responsibility early on?2. Evaluate Nike’s response to societal and consumer concerns about its contract

manufacturing.3. What are the challenges facing Nike in the future?

SOURCES

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